Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.

*Click on a graph to see the full-sized version

Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money Market diagram.

This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.

You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.

First watch this video lesson, which defines and introduces the money market diagram (skip ahead to 0:43 to hear the definition and explanation of the money market):

Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.

When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.

However, since the money demand curve depends on the level of transactions going on in a nation’s economy in a particular period of time, an increase in government spending on infrastructure, defense, corporate subsidies, tax rebates or other fiscal policy initiatives will increase the demand for money, shifting the Dm curve rightward and driving up interest rates. The higher interest rates resulting from the greater demand for money reduces the quantity of private investment; in this way the crowding-out effect can be illustrated in the money market.

Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.

Watch this video for a clear explanation of the loanable funds market and how it can be used to illustrate the crowding-out effect (skip ahead to 3:18 for a definition and explanation of the loanable funds market):

Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.

Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.

• When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
• The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
• In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
• As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
• This causes crowding out of private investment.

Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.

• Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
• Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
• This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.

What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.

On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).

It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.

At this point in the course, you may find yourself asking, “what is the difference between microeconomics and macroeconomics?” It has been a long time since we first defined these terms at the beginning of the course. The purpose of this post is to introduce some basic Macro concepts help clear up the confusing and not so obvious differences between these two areas of economics.

A teacher of mine once explained the difference between micro and macro using the example of a tree and a forest. Microeconomics is the like the study of an individual tree, standing in a thick forest of thousands of individual trees of different species. A microeconomist might study the systems that make an individual tree function efficiently, providing it with the sustanence it needs to thrive in the forest. A macroeconomist, however, will take a broader look at the forest as a whole, and observe how the thousands of trees work together in conjunction with the sun, the soil, the oxygen, nitrogen, and H2O in the environment that make the entire forest function efficiently as one giant organism.

Put literally, the tree is like an individual market. This may be a product market like the market for apples, or a resource market like the market for apple pickers. Microeconomists will study the characteristics of an individual market: the firms and their costs, tradeoffs, challenges presented by competition or the inefficiencies that result from a lack thereof, and the buyers in the market: the alternatives and trade-offs they face, the utility they receive and the decisions they make based on these factors. Microeconomics concerns itself not with the health of the economy as a whole, rather with the individual markets, firms, and consumers within the economy, and the challenges of efficiency and resource allocation faced by those markets.

Macroeconomics, on the other hand, studies the health of the economy as a whole. Macro deals with aggregates, or “collections of specific economic units treated as if they were one. ” For example, instead of studying price of a product, as a microeconomist would, a macroeconomist looks at the price level in the whole economy. Whereas a microeconomist looks at supply and demand in a particular market, a macroeconomist studies aggregate supply and aggregate demand, assessing the collective marginal benefit of all consumers and marginal costs of all producers. Instead of quantity supplied, the macroeconomist examines aggregate output, or gross domestic product. Instead of underallocation and overallocation of resources, the macroeconomists concerns himself with unemployment and inflation.

When it comes to the role of government, macroeconomics has a lot more to say about the role a central government should play in managing the economy as a whole. One major theme of microeconomics is that competitive markets, when left alone by government, tend to achieve efficient allocations of resources. You’ll find that in Macro, however, the government often plays a central part in stimulating and slowing down the level of economic activity in the economy, using tools such as fiscal and monetary policy.

Also in macroeconomics, we’ll study in more depth the role that comparative advantage plays in the economic exchanges that take place between nations. International trade also involves the exchange of foreign currencies, which we’ll try to understand by studying exchange rates and the role that governments play in manipulating and controlling the values of their currencies.

Macroeconomics will prove to be particularly relevant to the events going on in the recent turbulent global economy.  If have listened to the news lately you’ve heard world leaders, political pundits and commentators from all political and economic leanings use words like “bailout”, “fiscal stimulus”, “monetary easing”, “deficit spending” and others; all concepts having to do with macroeconomics. In the next few months, you will begin to see the forest through the trees as we take on the exciting  and challenging field of macroeconomics.

Assignment: Using your economics text and the Economic Dictionary at Econclassroom.com, complete the table below.

• On the left are microeconomics concepts you have already studied as part of the course. Each of these  concepts needs to be defined or explained. 
• In the right column are the macro concept that corresponds with each of the micro concepts. Each of these terms or concepts needs to be defined and/or explained. 

A theory of fiscal policy: Self-sustaining stimulus | The Economist

Expansionary fiscal policy is a tool governments often turn to when the economy is facing high unemployment and sluggish or negative economic growth. Cutting taxes and increasing government spending can contribute to the overall demand in the economy and thereby lead to job creation and economic growth.

One of the oldest arguments against stimulus, however, is that which says when a government borrows money to pay for such a policy, it can lead to a decrease in private investment and a decrease in future demand as the higher level of debt must be paid back in the future. Short-term stimulus, therefore, is counter-productive since any debts incurred must be paid back in the future, leading to lower levels of spending and therefore higher unemployment sometime down the road.

The crowding-out effect of fiscal policy is explained in detail in the following video from The Economics Classroom:

A recent study by two leading American economists provides an argument against this view of the crowding-out effect of fiscal policy:

In a new paper* written with Brad DeLong of the University of California, Berkeley, Mr Summers, now at Harvard after a stint as Barack Obama’s chief economic adviser, says that in the odd circumstances America faces today temporary stimulus “may actually be self-financing”…

Mr DeLong and Mr Summers are careful to say stimulus almost never pays for itself. When the economy is near full employment, deficits crowd out private spending and investment. In a recession the central bank will respond to fiscal stimulus by keeping interest rates higher than they would otherwise be. Both effects mean that in normal times the fiscal “multiplier”—the amount by which output rises for each dollar of government spending or tax cuts—is probably close to zero.

The “multiplier” referred to here is what economist refer to as the Keynesian spending multiplier, which is based on the theory that any increase in spending in an economy (say, through a new government spending package), will lead to further increases in spending (as households feel more confident and firms start to hire workers again), therefore the final change in national income resulting from a fiscal policy will be greater than the initial change in spending itself. This multiplier effect has formed the basis of the argument for expansionary fiscal policy since Keynes articulated it in the 1930’s.

The multiplier effect is explained in detail in the following video lesson:

If the multiplier is ZERO, there is no point in engaging in expansionary fiscal policies since there will be no additional increase in output as a government goes into debt to pay for a tax cut or an increase in spending. In the US today, argue Summers and Delong, the multiplier is probably not zero. Additionally, crowding-out is unlikely to occur.

Such constraints are not present now (meaning in the United States in 2012). Investment and demand are deeply depressed and the central bank, having cut interest rates to zero, is not about to raise them. The multiplier is higher than usual as a result…

Basically, Summers and Delong are trying to argue that the US government should engage in another round of fiscal stimulus, to offer additional support to the economy beyond 2009’s “Obama stimulus” and the current bill being debated in Washington, the American Jobs Act, a $470 billion tax cut and spending bill aimed at keeping unemployment from rising in America.

On one side of this debate are those like Summers and Delong who argue fiscal stimulus can pay for itself since it can leads to a larger increase in GDP than the increase in the government’s budget deficit needed to finance the stimulus. On the other side are those “deficit hawks” who believe that any increase in government debt will lead to a fall in current and future aggregate demand from the private sector, and therefore expansionary fiscal policies will just be crowded out by declining private sector spending.

By understanding the circumstances in which crowding-out is most likely and unlikely to occur, we should be able to make a more informed decision about future fiscal policy decisions. As these two economists argue, and as I have tried to present in this post and in a previous post A Closer Look at the Crowding-out Effect, today’s economy provides policy-makers with the perfect opportunity to stimulate aggregate demand by increasing the deficit and providing the US economy with the boost in demand it needs to get America back to full employment.

Discussion Questions:

1. Why is crowding-out more likely to occur when an economy is already producing at or near its full employment level of output than when an economy is in recession?
2. How are the theories of crowding-out and the multiplier effect used to argue for two different sides in the debate over the use of expansionary fiscal policy?
3. Why might a government deficit, paid for with borrowed money, lead to an expectation of a future increase in taxes?
4. Do you believe the government should take action during periods of economic hardship, or should it just get out of the way and let the economy “correct itself”?

The folks at my favorite podcast, NPR’s Planet Money, recently produced a five minute video answering the questions, “What is GDP?”. This could be a good resource when introducing the topic to high school students:

Time is Money [ 9:50 ] Play Now | Play in Popup | Download (9048)

Over the weekend I watched the new Justin Timberlake movie, In Time. In this edition of Welker’s Wikinomics Podcast I analyze the movie’s basic premise from a macroeconomic viewpoint.

Listen to the podcast, and then answer the discussion questions at the bottom of this post.

Discussion Questions:

1. Why does increasing the supply of money cause the demand for goods and services to rise?
2. Why does increasing the supply of money ultimately cause the supply of goods and services to fall?
3. When would an increase in the money supply be most inflationary, when an economy is producing close to its full employment level or when an economy is experiencing a recession? Explain.
4. With the help of a money market diagram and an aggregate demand / aggregate supply diagram, illustrate the effects of Will and Silvia’s re-distribution of time on the Ghetto’s economy.
5. According to Friedman, expansionary monetary policy cannot contribute to a nation’s long-run economic growth. What types of government policies can be implemented to promote economic growth in a nation?

Podcast Credits: 

• Intro song: The Rolling Stones – Time is On My Side
• Ending song: Pink Floyd – Money
• Milton Friedman quotes – Donahue, 1980

The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:

• Price level stability
• Full employment, and
• Economic growth

source: http://www.beaumontenterprise.com/

 

The activity below is to introduce Economics students to the three primary Macroeconomic objectives of any government or policy making body. These are :

Full employment of the nations work force: This means that nearly everyone who wants to work in the country is able to find a job. It does not mean that there is no unemployment, rather that the unemployment that does prevail in the economy is voluntary, i.e. it exists because workers are simply not willing to work at the prevailing wage rate. If there is involuntary unemployment in the economy, then the country is not meeting its macroeconomic objective, and there is likely a recession caused by a lack of overall demand (aggregate demand) for the nation’s goods and services.

Resources for learning about Full Employment:

• Textbook (Welker’s IB Economics for the IB Diploma) pages 286 – 288, 295-299.
• Reffonomics – Measuring Unemployment
• Reffonomics – the Types of Unemployment
  
• Reffonomics – Unemployment and Employment Quiz

Price level stability: Changes in the average price level of goods and services in the nation are measured by calculating inflation, commonly using a consumer price index to do so. Low and stable inflation is one of the macroeconomic objectives since price level volatility (high inflation or deflation) has several harmful effects on a nation’s households and business firms. Keeping inflation low and stable promotes a healthy environment for achieving business investment, full employment and economic growth

Resources for learning about Price level stability:

• Textbook pages 302-303, 306-307, 311-314
• Reffonomics – Calculating Inflation using a CPI
• Reffonomics – The effects of inflation
• Reffonomics – Inflation Quiz

Economic growth: The third macroeconomic objective is to increase the output of the nation’s goods and services year after year. Economic growth refers to the increase in real Gross Domestic Product (GDP) and can be measured by finding the total value of a nation’s output one year, comparing it to the previous year, and adjusting it for any changes in the price level between the years. Economic growth is a desirable goal because it generally means that incomes are rising and people’s lives are getting better. Of course, GDP only measures the physical output of goods and services, and does not include many non-economic variables that also should be considered when measuring people’s well-being. But rising incomes and output are deemed worthy goals since they are associated with rising living standards.

• Textbook pages 244, 251-253, 337-340
• Reffonomics – Real GDP lesson
• Reffonomics – Real GDP Multiple Choice Quiz

Assignment: Complete the readings and online activities above. Then use the data in the table linked below to answer the quesitons that follow.

Questions:

1. Calculate the unemployment rates for each of the years in the table. Describe what happened to unemployment over the years displayed.
2. Calculate the inflation rates between each of the years in the table. Describe what happened to inflation over the years displayed.
3. Calculate the Real GDP for each of the years in the table.
4. Calculate the Real GDP growth rates between each of the years in the table. Describe what happened to real GDP from one year to the next in the years displayed.
5. Describe the relationship between the inflation and unemployment rates you calculated for each of the years. Is there any correlation in how the figures change from year to year?
6. Based on your analysis of the data above, to what extent has the United States succeeded in achieving its three macroeconomic objectives of:

• Full employment?
• Price level stability?
• Economic growth?

Parliament gives green light to government economic boost plan. – swissinfo

In the last two weeks, both my countries, America and Switzerland, have put forward stimulus packages aimed at helping their economies avoid entering a second recession. The US American Jobs Act, announced by President Obama to the US people two weeks ago today, will provide relief to American businesses and households mostly in the form of tax cuts. Some new spending on infrastructure, primarily schools and transportation, is provided, as is continued relief for unemployed Americans.

The chart below shows how the American Jobs Act plans to spend the proposed $447 billion. 

Clearly, the largest single category of spending proposed by the AJA is in the form of tax cuts for American households and firms (a combined 54.8% of the total). The purpose of tax cuts, of course, is to provide households with more disposable income with the hope that household consumption will increase, thereby increasing demand for goods, services, and ultimately labor, which would bring down unemployment. Businesses will also enjoy a cut in the taxes they pay when employing workers, so the costs to firms that hire new workers will be lower if the bill is passed. Extending benefits to workers who are already unemployed makes up a relatively small component of the American stimulus plan, while infrastructure and education spending, both which contribute to the long-run growth potential of the US economy, make up less than a third of the $447 billion package.

Let’s now look at the Swiss stimulus package, approved by the Swiss parliament today following a debate that lasted just seven hours. (For comparison, the American Jobs Act will require months of deliberation and when it is ultimately passed will likely have been completely modified by the American congress). The chart below shows where the $950 million of spending announced by Switzerland will be spent.

The biggest difference, as can be seen, is that a full 57.5% of the Swiss stimulus comes as relief for unemployed Swiss workers, compared to just 14% of America’s package. The 24.4% spent on research and development will go towards “a research and innovation programme, helping to translate ideas into successful business plans.” The subsidies for Switzerland’s tourist industry will come in the form of low-interest loans to businesses in the hotel and travel industry, which has been adversely affected by the recent appreciation of the Swiss franc, which has reduced tourism in Switzerland as Europeans and others have found it more expensive to travel to the country in recent months. Tourism is one of the largest sectors in the Swiss job market, so the spending on unemployment benefits will bring direct relief to individuals affected by that industry.

To compare the two country’s stimulus packages (America’s is only in the proposal stage, while Switzerland’s has been approved and will begin being implemented soon), is a study in two different economic philosophies. One major difference is the obvious lack of tax cuts in the Swiss plan. Such cuts were proposed by the conservative party in Switzerland, but the country’s finance minister, supported by the center-left party, argued that “tax policy should not be shaped by the current monetary situation.” She is referring to the fact that Switzerland’s stimulus in needed in response to the strong Swiss franc, not due to any underlying problems in the Swiss economy. The Swiss plan targets relief directly at those industries affected by the strong currency, tourism and high skilled manufacturing, which stands to benefit from increased spending on R&D. 

The US plan, on the other hand, includes over $240 billion (almost 55% of the total) in tax cuts, which while they do increase households’ disposable incomes, do very little to guarantee an increase in total spending in the economy. The last two rounds of stimulus in the United States, the 2009 American Recovery and Reinvestment Act, and the 2008 tax rebate program under George W. Bush, both included significant tax cuts to Americans (all of the Bush stimulus was a tax refund). Neither of these packages produced much growth for the United States, although the ARRA likely prevented unemployment from rising higher than it would have without a stimulus.

Switzerland’s plan includes no tax cuts, instead it offers direct support to particular industries in the form of government spending, and helps unemployed workers continue to spend and contribute to aggregate demand by maintaining their incomes during their period of unemployment. Switzerland’s stimulus, it could be argued, is more of a demand-side fiscal stimulus than America’s, which, due to its large tax cuts, places more of the responsibility for increased aggregate demand on the private sector. However, the 31% of the American plan that goes towards school and transportation infrastructure, and the 14% that goes towards continued unemployment benefits, should have positive demand-side effects, and should help increse employment and output in America if the bill is passed.

Discussion Questions:

1. What is meant by the claim that Switzerland’s stimulus package is more of a demand-side policy than the United States’? How will the various types of spending in the Swiss plan contribute to the country’s aggregate demand?
2. Another difference between the two plans is how they will be paid for. In Switzerland, “the money is to be taken from an expected 2011 budget surplus,” while the US budget for 2012 is expected to have a deficit of around 10% of the country’s GDP. How does the budget situation in the two country’s impact the ability to use fiscal expansionary fiscal policy to promote the macroeconomic objective of full employment?
3. Which is more likely to have a direct expansionary effect on aggregate demand, tax cuts of a certain size or government spending of the same size? Explain your answer.

Once again, my IB Economics students are working on yet another Internal Assessment Commentary, this time on syllabus section 3, Macroeconomics. Since they found my sample Microeconomics commentary so helpful, I thought I’d punch out a quick sample of a macro commentary for them and for anyone else who is working on their IB Economcis Internal Assessment.

The commentary below (not including the selection from the article) is 749 words in length. This does NOT include words in the graphs, so let’s not have that debate in the comment section. The new IB economics internal assessment model (first examinations 2013) will not count words on graphs, so this sample commentary is perfectly suited for the new assessment model. If you’re a 2012 student, you would be wise to count words in graphs as part of your word count.

If you like what you see, or have any quesitons, please leave your comments below the post.

Article highlights:

An Impeccable Disaster – NYTimes.com

Paul Krugman clearly explains the problems faced by two or Europe’s largest economies today:

So why is Spain — along with Italy, which has higher debt but smaller deficits — in so much trouble? The answer is that these countries are facing something very much like a bank run, except that the run is on their governments rather than, or more accurately as well as, their financial institutions.

Here’s how such a run works: Investors, for whatever reason, fear that a country will default on its debt. This makes them unwilling to buy the country’s bonds, or at least not unless offered a very high interest rate. And the fact that the country must roll its debt over at high interest rates worsens its fiscal prospects, making default more likely, so that the crisis of confidence becomes a self-fulfilling prophecy. And as it does, it becomes a banking crisis as well, since a country’s banks are normally heavily invested in government debt.

Now, a country with its own currency, like Britain, can short-circuit this process: if necessary, the Bank of England can step in to buy government debt with newly created money. This might lead to inflation (although even that is doubtful when the economy is depressed), but inflation poses a much smaller threat to investors than outright default. Spain and Italy, however, have adopted the euro and no longer have their own currencies. As a result, the threat of a self-fulfilling crisis is very real — and interest rates on Spanish and Italian debt are more than twice the rate on British debt.

Commentary:

The European Central Bank (ECB) is engaging in a new form of monetary policy in which it buys government bonds directly from the Spanish and Italian governments. Essentially, the goal is to bring down the interest rates on Italian and Spanish government bonds, which should reassure private investors that Italy and Spain will be able to pay them back and thus reduce the upward pressure on interest rates in the Eurozone, a situation which threatens to reverse the already sluggish recovery from the recessions of 2008 and 2009.

Monetary policy refers to a central bank’s manipulation of the money supply and interest rates, aimed at either increasing interest rates (contractionary monetary policy) or reducing interest rates (expansionary monetary policy). The ECB is currently buying government bonds from European governments, effectively increasing the supply of money in Europe with the hope that more government and private sector spending will move the Eurozone economy closer to its full employment level of output, at which workers, land and capital resources are fully employed towards the production of goods and services.

If successful, the ECB’s “quantitative easing”, as the new type of monetary policy is known, should bring down interest rates on government bonds and thereby reallocate loanable funds towards Italy and Spain’s public and private sectors.  The increase in supply of loanable funds should bring down the private interest rates available to borrows (businesses and households), making private investment more attractive.

The ECB’s bond purchases make it cheaper for Italy and Spain to borrow, lowering the interest rates on their bonds, restoring confidence among international investors, who may be more willing to save their money in Italy in Spain. The inflow of loanable funds into these economies (seen as an increase in the supply of loanable funds from S1 to S2) should bring down private borrowing costs (the real interest rate), encouraging more firms to invest in capital and more households to finance the consumption of durable goods, increasing aggregate demand and moving the Eurozone economy back towards its full employment level of output, from AD1 to AD2 in the graph on the right.

In certain circumstances, monetary easing like this could be inflationary, but in reality inflation is unlikely to occur given the large output gap in Europe at present (represented above as the distance between Y1 and the dotted line, signifying the full employment level of output). Any increase in aggregate demand will lead to economic growth (an increase in output), but little or no inflation due to the excess capacity of unemployed labor, land and capital resources in the European economy today.

With private sector borrowing costs increasing due to growing uncertainty over their deficits and debts, the Italian and Spanish governments will find expansionary fiscal policies (tax cuts and increased government expenditures) are unrealistic options for achieving the goal of full employment. The ECB, however, as Krugman argues, should continue to play an increasing role in the expansion of credit to cash strapped European governments, with the aim of keeping interest rates low to prevent the crowding-out of private spending that often occurs in the face of large budget deficits. Inflation, always a concern for central bankers, should be a low priority in Europe’s current recessionary environment. Only when consumer and investor confidence is restored, a condition that requires low borrowing costs, will private sector spending resume and the Euro economies can begin creating jobs and increasing their output again.

In the short-term, Italy and Spain should take advantage of the ECB’s bond-buying initiative, and make meaningful, productivity-enhancing investments in infrastructure, education and job training. If their economies are to grow in the future, Eurozone countries must become more competitive with the rapidly expanding economies of Asia, Eastern Europe, and elsewhere in the developing world.

In the medium-term, the Eurozone countries must demonstrate a commitment to fiscal restraint and more balanced budgets. Eliminating loopholes that allow businesses and wealthy individuals to avoid paying taxes, for example, is of utmost importance. Also, increasing the retirement age, downsizing some of the more generous social welfare programs and increasing marginal tax rates on the highest income earners would all send the message to investors that these countries are commited to fiscal discipline. Then, in time, their dependence on ECB lending will decline and private lenders will once again be willing to buy Eurozone government bonds at lower interest rates, allowing for continued growth in the private sector.